Annual Report - CoBank

Credit ApprovalThe most critical element in managing and controllingrisk in the extension of credit is the initial decision to make aloan and the resulting structure and terms of the relationshipwith the borrower.We place significant emphasis on the evaluation andunderstanding of a borrower’s management and business, theinitial credit analysis and the approval process. We emphasizecash flow and payment capacity as primary sources forrepayment of loans, while collateral is normally considered asecondary source of repayment. In circumstances where thecredit decision places substantial reliance on collateral torepay the loans, independent appraisals may be used to assistin the collateral valuation. Such appraisals are conducted inaccordance with FCA regulations and professional appraisalstandards.The earnings, capital and loan loss reserves of theAssociations provide us a buffer from losses in their respectiveloan portfolios. Loans to our affiliated Associations aregoverned by a General Financing Agreement, as described inNote 17 to the accompanying consolidated financialstatements.With the exception of certain small-dollar leasetransactions, no single individual is granted credit approvalauthority within CoBank. All approvals or credit actionsrequire formal documentation. Management assigns a riskrating to each borrower based on two measurements:probability of default (PD) and loss given default (LGD). ThePD rating system uses a 14-point scale of 1 (highest quality) to14 (lowest quality). The PD rating is primarily determined bythe financial characteristics of the borrower and reflects theprobability of default driven by several factors, includingbusiness risk, industry risk, management capability andfinancial condition. The LGD rating is intended toapproximate the degree of potential loss in the event theborrower defaults.Exposure and Concentration LimitsWe make extensive use of exposure limits to manage riskand volatility in the loan portfolio. Exposure to individualborrowers and related entities is managed through a riskmatrix that considers the dollar exposure, type of exposure andrisk rating of the borrower. Individual borrower exposures areexamined at the time of each borrower’s formal review, whichoccurs at least annually. The dollar exposure, risk rating andtype of credit extended further determine the delegated levelof authority required to approve the credit. These individualborrower exposures are then further subject to total portfoliolimits on exposure to different industries and countries.Exposure limits for different industries are reviewed quarterlywhile exposure limits for different countries are reviewedannually. We allow for more frequent evaluation whennecessary. Exceptions to these exposure limits may be grantedby the CLC if conditions warrant.We also manage lending credit exposures andconcentrations by selling and purchasing loans. Ourcapabilities in selling and purchasing loans will continue to becritical to managing the portfolio and maintaining marketdiscipline.While we believe these standards, processes and tools areappropriate to manage our credit risk, there is no assurancethat significant deterioration in loan quality will not occur,which could reduce our future earnings.We are limited to making loans and providing relatedfinancial services to eligible borrowers in certain specifiedindustries, as mandated by the Farm Credit Act. As a result,we have a concentration of loans to the agricultural and ruralinfrastructure industries. The significant risk factors affectingcredit conditions in these industries within each of ouroperating segments are described below.AgribusinessThe relationship of demand for and supply of U.S.agricultural products in a global marketplace can significantlyimpact the volume, earnings and loan quality of ourAgribusiness portfolio. In addition, changes in credit marketscan affect our ability to buy and sell loans in this portfolio.Changes in the prices of agricultural commodities canimpact the profitability and loan quality of a significantportion of our Agribusiness customers. Changes in prices foragricultural commodities result from, among other factors,seasonal weather conditions; changes in the production levelsof ethanol, which can be impacted by legislative initiatives,the price of oil and other factors; financial investment in thecommodity futures markets by non-agricultural interests; andchanging export markets. Market prices for food products alsohave a significant affect on a number of customer sectorswithin our Agribusiness portfolio.Major international events, including military conflicts,terrorism, political disruptions or trade agreements can affect,among other things, the price of commodities or products usedor sold by our borrowers or their access to markets. Inaddition, biological or disease risk in human or livestockpopulations can impact the supply of and demand foragricultural products. Certain of our customers also haveexposure to counterparties in the commodities exchangemarkets.U.S. agriculture receives financial support from the U.S.government through direct payments, crop insurance and otherbenefits. While U.S. government support for agriculture hasbeen consistent, there is no assurance that such financialsupport will remain at current levels, especially given recentdiscussions surrounding the need to reduce federalgovernment spending. Although most of our customers do notgenerally receive direct support from federal programs, asignificant reduction or elimination of such support could havea negative impact on the loan quality of certain borrowers,including Associations, who derive a significant share of theirearnings from farmers who may be affected by such areduction. Other political, legislative and regulatory activitiesmay also impact the level or existence of certain governmentprograms.CoBank 2011 Annual Report44